Idiosyncratic Volatility, Return Reversals and Momentum: Australian Evidence

Abstract

This paper examines the interaction between short-run return reversals, momentum and idiosyncratic volatility in the Australian market. We confirm that stocks with high idiosyncratic volatility earn low average returns over the next month. Unlike US studies which attribute this negative relation to short-run return reversals, we find that it is partly caused by a group of loser stocks (formed over one month) which continue to exhibit negative return drift (over the next month). We also investigate whether these stocks continue to display negative returns over longer horizons. In turn, we broaden our study to examine whether the momentum effect is persistent in stocks with high idiosyncratic volatility. We find that stocks with high idiosyncratic volatility realize significant abnormal momentum returns over a six-month holding period relative to stocks with low idiosyncratic volatility. As we document the persistence of momentum profits amongst stocks with high idiosyncratic volatility, our work contributes to the existing literature which suggests that idiosyncratic volatility is an important limit to the arbitrage of the momentum effect.